S corporation current developments: S corporation eligibility and elections, operations, procedural changes and reorganizations.

• Author: Karlinsky, Stewart S.

From a tax perspective, the period covered in this update - Sept. 1, 1992 through July 15, 1993 - has been a busy one for S corporations and their shareholders. Several proposed and final regulations were issued, a few court cases (including a Supreme Court decision) were decided, and some revenue rulings and a plethora of private letter rulings were released. Although private letter rulings are not determinative for anyone but the requesting taxpayer, they give a sense of the direction in which the Service is moving, and are substantial authority for taking tax return positions; the results of inadvertent termination requests are also of practical interest to practitioners advising S corporations. This article will cover current developments in five major categories: eligibility and elections; operations; procedures; reorganizations; and regulation projects and the Revenue Reconciliation Act of 1993 (RRA).

Eligibility and Elections

With S corporations the entity of choice for many small businesses, it is not surprising that issues involving corporate and shareholder eligibility have generated numerous rulings.

* Shareholder eligibility

Trusts: In trying to keep the S corporation rules simple, there are significant limitations on who is an eligible shareholder. One of the areas of greatest confusion seems to be what type of trust qualifies as a shareholder. It is clear that voting trusts and revocable living trusts qualify as shareholders. In Rev. Rul. 92-73,(1) the IRS made it clear that a qualified Sec. 408(a) individual retirement account (IRA) is not eligible as an S shareholder. Of some consolation to the taxpayer, a letter ruling may be requested so that the inadvertent termination rules of Sec. 1362(f) may apply. This is exactly what was done in Letter Ruling 9324012,(2) in which an S corporation sold stock to two IRAS in 1988. Four years later, a new accountant discovered the mistake and the corporation redeemed the IRA-held stock. The government allowed the corporation to retain its S status.(3)

Similarly, in Letter Ruling 9241029,(4) an S corporation issued shares of its stock to an IRA. Ten months after issuance, the error was discovered and the corporation immediately canceled the IRA's stock certificate and reissued it in the name of the individual. The IRS treated the events as an inadvertent termination and allowed the corporation's S status to continue uninterrupted. QSSTs: In the eligibility arena, the qualified subchapter S trust (QSST) rules are often not precisely followed. Usually, the beneficiary forgets to elect to be qualified shareholder.(5)

In Letter Rulings 9325035, 9325036 and 9325037,(6) the Service said that when a minor is the sole beneficiary of a QSST, the parent's signing of the Form 2553, Election by a Small Business Corporation, was in substantial compliance with Sec. 1,361(d)(2) and, therefore, a valid S election was in effect.

In Letter Ruling 9325034,(7) S stock was transferred to a testamentary trust that also qualified as a QSST. The deceased shareholder's surviving spouse did not make a timely QSST election under Sec. 1,361 (d)(2). The IRS granted inadvertent termination status under Sec. 1362(f).

In another QSST-related ruling (Letter Ruling 9305020(8)), a qualified trust did not currently distribute the income received from the S corporation. It applied for and received inadvertent termination relief after it promptly cured the error by distributing the income to the beneficiary.

In Rev. Rul. 93-31,(9) the QSST rules endangered an S corporation's eligibility. A trust was established with two beneficiaries and was treated under Sec. 663(c) as two separate trusts. The two beneficiaries properly elected to be S shareholders. The problem was that the trust agreement allowed the (remote) possibility that the trustee could invade corpus of one trust for the benefit of the other trust's beneficiary for health, education, support or maintenance. This was in technical violation of the QSST rules and, therefore, S status was terminated. Testamentary bypass trusts are often structured this way. However, if an S corporation is involved, the tax adviser should set up multiple trusts rather than using only one trust with multiple beneficiaries.

In contrast to this revenue ruling, in Letter Ruling 9326046(10) a trust document could be modified to allow a trust with a sole beneficiary to qualify as a QSST. One of the modifications was that the trustee have the power to invade corpus for the beneficiary's support and maintenance during her life. The basic distinction between these two rulings was that in the revenue ruling there were two beneficiaries with the possibility existing that one might receive corpus that was attributed to the other beneficiary, while in the letter ruling there was only one beneficiary, so there was no possibility of anyone else sharing in the corpus while that beneficiary lived.

Partnerships: Obviously, a partnership is not an eligible shareholder, even if all its partners are qualified individuals. Nevertheless, mistakes are made and in Letter Ruling 9312021(11) the Service granted inadvertent termination relief even though two partnerships owned the S corporation's stock for over a year.

* Corporate eligibility

Affiliated corporations: In Letter Ruling 9323017,(12) the IRS permitted a new S corporation to continue its status even though it established an active 100%-owned subsidiary three months after electing S status. It sold the subsidiary to one of its shareholders seven months later. Three years after that, it discovered that affiliated group status had terminated its S election. It received an inadvertent termination ruling. In Letter Ruling 9322030,(13) an affiliated group was formed when an S corporation acquired control of another corporation. When they discovered the error, the companies merged. The IRS granted inadvertent termination relief.

Similarly, in Letter Ruling 9326012,(14) an S corporation owned 79% of another corporation. The external auditors suggested to...